Money multipliers and Basel III liquidity rules

Good Vox article by Manmohan Singh and Peter Stella about the transmission of monetary policy.

Textbooks tend to assume a very simplified model of the money creation process, in which central banks have direct control over the quantity of monetary base (i.e. currency plus commercial bank deposits at the central bank). The relationship between this monetary base and the total money supply is then governed by something called the ‘money multiplier’. This money multiplier relationship may arise due to legal minimum reserve requirements, which limit the amount of deposits a commercial bank can accept (and hence the amount of loans it can make) by the need to always hold the equivalent of X% of deposits in the form of reserves at the central bank – the quantity of which, as I said, the central bank directly controls.

I’ve always thought this model was odd. This is not least because, when I as an undergrad first looked in to what these ‘reserve requirements’ were, one of the first things I discovered is that we in the UK didn’t have a minimum reserve requirement – so in theory, banks could create an infinite amount of money from a given amount of monetary base.

Singh and Stella point out a further flaw. In today’s financial system, so-called ‘shadow banks’ (hedge funds, money-market funds, etc) clearly play a big role in the money creation process. But as well as not being subject to minimum reserve requirements, shadow banks also don’t have access to central bank deposit facilities. Therefore, for their liquidity needs, they have to rely much more on private sources – such as private repo markets. These typically require high-quality, highly-liquid assets (such as government bonds) as collateral, so shadow banks will hold such securities as their ‘reserves’.

Which leads on to Singh and Stella’s point – quantitative easing, in which the Fed and Bank of England bought up government bonds from banks, merely substituted ‘public’ bank reserves (i.e. new commercial bank deposits at the central bank) for ‘private’ reserves used by shadow banks (i.e. high-quality government bonds that were taken out of circulation). The true amount of monetary base was unchanged; so even for a given money multiplier, there will be no increase in the wider money supply.

And as a result, it’s incorrect to assume that the massive increase in measured monetary base since the crisis (Singh and Stella point out that deposits at the Fed increased from $20.8bn in 2007  to $1562.3bn in 2011) will be be inflationary – as there’s not a knock-on increase in the wider money supply.

Anyway, a (not-fully-formed!) thought follows on from this. The Basel 3 liquidity rules drawn up after the 2008-09 crisis will require banks to hold more liquid assets. I think these rules can be interpreted as a substitute for old-fashioned minimum reserve requirements, i.e. making sure that banks hold a sufficient chunk of liquid assets that enable them to meet deposit outflows. (Interestingly, the UK’s Financial Policy Committee recently left the door open to asking for powers to vary banks’ liquidity buffers over time, analogous to using minimum reserve requirements as a policy tool as is often the case in emerging market economies.)

But the Basel 3 liquidity rules’ definition of liquid assets will include both central bank reserves (i.e. Singh and Stella’s ‘public’ reserves) and high-quality sovereign debt (i.e. ‘private’ reserves). What does that mean for the money multiplier – in a world where Basel 3 supplants minimum reserve requirements as the binding constraint even for banks, does the concept of a conventional money multiplier relationship make even less sense?


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